Computer Sciences F2Q09 (Qtr End 10/03/08) Earnings Call Transcript

Nov.12.08 | About: Computer Sciences (CSC)

Computer Sciences Corporation (NYSE:CSC)

F2Q09 (Qtr End 10/03/08) Earnings Call

November 12, 2008 5:00 pm ET

Executives

Bill Lackey - Director of IR

Mike Laphen - Chairman and CEO

Don DeBuck - Interim CFO

Analysts

Rod Bourgeois - Bernstein

Adam Frisch - UBS

Bryan Keane - Credit Suisse

Moshe Katri - Cowen & Company

George Price - Stifel Nicolaus

Vincent Lin - Goldman Sachs

David Grossman - Thomas Weisel

Greg Smith - Merrill Lynch

Operator

Good day everyone and welcome to the CSC fiscal year 2009 second quarterly earnings conference call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Mr. Bill Lackey, Director of Investor Relations. Please go ahead, sir.

Bill Lackey

Thank you, Operator and good afternoon everyone. Welcome to CSC's second quarter fiscal 2009 earnings conference call. We hope you've had a chance to review our financial results issued earlier this afternoon.

With me this afternoon are Mike Laphen, Chairman and Chief Executive Officer, who will begin with some opening remarks, and then Don DeBuck, Interim Chief Financial Officer will review the quarters’ financials.

As usual, this call is being webcast live at csc.com, and we also welcome those joining us via that process.

Additionally we have slides posted on csc.com, which accompany our presentation today. As always, I must caution everybody that any statements on this call that are not historical facts may be considered forward-looking statements under the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are subject to known and unknown risks and uncertainties, which could cause actual results to differ materially from those expressed in or implied by these statements.

Additional information concerning these risks and uncertainties is contained in the company's filings with the SEC. Copies of these filings are available from SEC's, from CSC's website at www.csc.com or from us at Investor Relations.

Our presentation today includes certain non-GAAP financial measures. In an effort to provide additional information to investors, all non-GAAP measures have been reconciled to their related GAAP measures in accordance with SEC rules.

You will find a reconciliation of these measures included in the tables attached to the earnings press release, and they also will be posted on the Investor Relations section of CSC's website.

Finally, we assume no obligation to update the information present on this conference call except as required by law. Now, if you’ll please turn to slide number five, I will turn the call over to Mike.

Mike Laphen

Thank you Bill, and good afternoon everyone. I'm again pleased to have the opportunity to speak with you about CSC's current business position, as well as our second quarter financial results.

As shown on Slide 5, highlights for the quarter include revenue of $4.2 billion, up 5.5%; EPS of $2.95, including the positive impact of the resolution of the IRS examination for tax years 2000 through 2004.

Operating cash flow of $401 million as reported; free cash flow performance improvement of $181 million over last year's second quarter; new bookings in the quarter of $4.6 billion, which is a 12% increase over Q2 last year.

Resolution of the IRS examination for tax years 2000 through 2004 was a significant event for CSC. Over and above its impact on EPS, this resolution had positive impacts on both the balance sheet and ROI.

Improving CSC's cash flow has been a major focus for the management team, and one that is doubly important in today's economic environment. Accordingly, I'm pleased to note our continued improvement in free cash performance and the 11 day reduction in DSO compared to last year.

This quarter also witnessed an important milestone in our NHS program, with the launch of Lorenzo and two earlier adopter sites. The CEO of University Hospitals of Morgan Bay has publicly expressed his support and confidence for the program, given the extensive testing and planning performed before deployment, and the immense benefit that will be available to medical personnel and patients through the system.

We are also actively engaged with the NHS in the south of the UK, which was previously managed by Fujitsu, and are encouraged by the level of interest in the NHS to have greater CSC involvement in that region.

In October, the commercial paper market became increasingly dysfunctional. So we decided it prudent to draw down in it’s entirety an existing credit facility of $1.5 billion. This action ensures we have access to more cash than needed for our near-term liquidity requirements and allows us the freedom to disengage from the commercial paper credit market.

Our operating margin in the second quarter was 6.7%, up 30 basis points sequentially from Q1. Notwithstanding this improvement, Q2 investments in new business activities and workforce realignment actions are expected to benefit second half margins.

Consequently, we are reconfirming guidance for March improvements of 25 or more basis points for the year. Our guidance for revenue and EPS has been adjusted to recognize the impact of the strong currency headwinds projected for the second half. Don will provide further details in his remarks.

Turning to slide number 6: Overall, revenue on an as reported basis grew 5.5%. Business Solutions and Services delivered 8% year-over-year growth. This line of business includes our commercial consulting and systems integration activities, business process outsourcing as well as other intellectual property-based solutions.

Global Outsourcing Services delivered approximately 6% growth year-over-year. In times of economic difficulty, the outsourcing component of our portfolio provides CSC with long-term recurring streams of revenue. Historically, during periods of economic distress, customers have been motivated to initiate or expand outsourcing relationships, even while constraining discretionary spend. Currently, our outsourcing pipeline stands at over $8 billion of opportunities.

Our North American Public Sector delivered 3% growth. The pipeline of awards from the six high growth market segments, such as identity management, health services, and logistics and transportation continues to be strong.

Overall, the opportunity set for North American Public Sector over the next 17 months is approximately $30 billion, with approximately $9 billion scheduled for award during the balance of this fiscal year. A public sector is an important market within CSC's portfolio. It operates in a manner largely independent of the overall economy, and it often operates counter-cyclically.

Turning to our vertical industry, slide number 7. We experienced growth in five of our six verticals with healthcare, manufacturing, and chemical, energy and natural resources leading the way. The growth in manufacturing derives from the propensity to outsource in difficult times, just as I have mentioned.

Within our Financial Services vertical, we have seen a lengthening of the decision making cycles for some types of discretionary spend. As conditions stabilize, we believe the services we offer will continue to be in demand, as they help companies to reduce costs, improve profitability and comply with their regulatory environment.

As we move to slide 8, we are pleased with our new business success and the balance and distribution of these awards across our three lines of business. The slide details our year-over-year progress for the second quarter, with its 12% growth. For the first half of fiscal year '09, bookings show a 45% growth over the first half of last year.

As shown on slide 9, we continue to expand our global operations and develop the capability offered throughout our World Sourcing network. Since the beginning of the calendar year, CSC has opened six World Sourcing centers, including centers in Lithuania, China, Vietnam, Malaysia and the US.

Having recently returned from our Board of Directors meeting in India, and visits to our Asia location and customers, I'm extremely pleased with our progress in adding local capability and capacity that extends value to these customers as well as those across the globe.

Going forward, as we move to slide 10, we know we are all operating in a tough environment that requires that we exercise caution and act prudently. We will continue to maintain our focus on tightening up our business operation, which includes managing our cash, mitigating our credit risks and exercising the fundamentals of expense control.

With respect to credit risks, we have implemented additional internal controls to mitigate our potential exposure to client credit risk. Our credit facility drawdown has removed our dependency on and the risk of a dysfunctional commercial paper market.

Additionally, this has further lowered our exposure to the long-term debt market, as we have the cash position necessary to repay the $200 million trench of long-term debt that matures in March 2009.

While current economic conditions will provide challenge, we must also take advantage of the market opportunities that will arise. These opportunities include providing high value solutions to help clients reduce their cost and be more profitable and competitive in this tough economic environment.

We currently have both BPO and outsourcing services in the market and have aligned our sales and marketing capability to capitalize on these opportunities for new business. Second marketing consolidation and changes in the regulatory environment are conditions that historically have created opportunity for our consulting businesses.

Thirdly, the depth and breadth of our services and presence across both the defense and civilian agencies within the US federal and the public sector markets within the UK, Continental Europe, and Australia, should provide future opportunity as administrations change and spending priorities shift in response to changing economic conditions.

Overall, we continue to focus on the items that are within our control and strengthen our business for future growth and improved revenue performance. While we can't control currency exchange rates which have become volatile, we will continue to manage the quality and performance of our businesses in local currencies, as this, in our experience has always proven to be the best long-term course of action.

In conclusion, we delivered profitable top line growth and improved cash performance during the first half. We have steadily made progress in delivering on our commitments to the NHS and against our long term strategy. Through prudent management, we have built a stronger foundation for continued operational performance and future growth.

Before I turn the call over to Don DeBuck, I'm pleased to share with you the news that CSC has appointed Michael Mancuso as Vice President and Chief Financial Officer effective December 1st, 2008.

Mike previously served as Senior Vice President and Chief Financial Officer of General Dynamics and has decades of experience in Executive Financial Management.

His broad experience leading global financial operations makes him a perfect fit for this role within CSC. And I look forward to working with him, as we continue to execute our strategic growth plan and position CSC for future success.

I’d like to take this opportunity to thank Don for his service as Interim CFO and for his many positive contributions to the company's progress. I look forward to his continued leadership and contributions to CSC's future growth and profitability.

I’ll now turn the call over to Don for further details on the quarter's financials.

Don DeBuck

Thank you, Mike and let me thank you especially for those kind words. It’s been a privilege to support you and the company in the Interim CFO overall for these past months. And I along with the rest of my finance colleagues look forward to supporting Mike.

So I'd also like to thank everyone for joining the conference call today. So let's start with the financial highlights on Slide 12 for the second quarter of the fiscal year 2009. Second quarter revenues grew 5.5% to $4.2 billion, with increases across all three of our lines of business. In constant currency revenues grew by 4.4%.

Operating income or OI was $282 million, resulting in 6.7% OI margin, compared to 6.8% last year, and was up 30 basis points sequentially. We’ll talk more about Q2 operating results in a few minutes, but our second quarter OI margin includes the impact of increased efforts around new business pursuits, a bit weaker financial services verticals than the comparable period last year, and some actions in our global outsourcing line of business.

Earnings per share of $2.95 includes $2.27 of net tax benefits in the tax line, along with $0.04 negative impact from IRS resolution advisory cost and adverse foreign exchange rate movements from our previous guidance. We will talk more about these in a minute.

We had free cash inflow of a $166 million, an improvement of $181 million compared to the same period last year. On a year-to-date basis, it's an improvement of $513 million comparing to last year first half.

The free cash flow performance does include some capital expenditure timing benefit compliance. DSO decreased to 91 days in the second quarter, an improvement of 11 days from the same period last year. We've been working hard on DSO and are encouraged by this quarter's results, following the first quarter's seven days improvement.

Let's move to Slide 13. We remain committed to providing additional explanations about our results. So the significant tax and foreign exchange impacts on our reported EPS figure of $2.95, but not contemplated in our guidance deserves some explanation.

Let's deal with the items affecting the tax line first. As announced in the second quarter, we finalized with the IRS a resolution of our fiscal 2000 through 2004 tax returns, resulting in an EPS benefit of $2.43.

As we said in our September 23 press release, this is a very significant milestone for CSC, with a resolution of some of our outstanding tax matters. We've now resolved with the IRS a number of complex tax issues covering 10 fiscal years in a period of 10 months.

Increased provisions for estimates under FIN-48 arising from recent international tax audits across three jurisdictions; resulted in a net $0.16 adverse impact for this quarter. Taken together, we get a net $2.27 EPS benefit in the tax line for these tax items this quarter.

Outside advisory cost, related to finalizing the IRS resolution, had approximately $0.02 of adverse EPS impact. These costs are in the corporate G&A line, and were due to outside assistance and review of the IRS agreement.

Finally, unfavorable exchange rate movement from the baseline of our guidance reduced EPS by about $0.02. Rates began to move sharply late in the quarter ending October 3rd. Current spot and forward rate yield a more pronounced impact on our second half projections. We'll return to that in a bit.

Netting these items which were not contemplated in our previous guidance, yield an adjusted $0.72 for EPS, which is within the range of our previous $0.70 to $0.80 guidance for the quarter. We'll talk later about the operating drivers and also what's driving our continued outlook for the full year.

Let's turn to Slide 14. Second quarter revenues were $4.2 billion, a growth of 5.5% as reported and on a constant currency basis, revenues increased by 4.4%. On a year-to-date basis constant currency rates is 8%, with as reported growth rate for the six months at 10.4%.

Now let's move to the next slide and break out revenue by our three lines of business. North American Public Sector or NPS generated revenues of $1.5 billion, 3% higher than the same quarter last year. An increase of $116 million in defense was offset by a decline of $54 million in the civil sector from contract completions. A significant portion of the growth was driven by the increase on the US Army strategic services sourcing contracts.

We now expect the full year NPS growth to be in the 5% to 7% range. At Global Outsourcing Services or GOS revenues grew 6% as reported to $1.7 billion, helped by a new business win in the manufacturing vertical, as well as some higher pass-through revenue on an aerospace contract, and other increases across multiple contracts.

Business Solutions and Services or BS&S revenues increased by 8%, as reported to $1.1 billion. The First Consulting Group acquisition contributed approximately five percentage points of growth within BS&S. Revenue from the National Health Service contract and project work in the Europe central region also contributed to the growth.

Offsetting these increases, BS&S financial services revenue declined due to decreases in software license sales in both the United States and Europe. Last year's second quarter was particularly strong for license sales, but that sector faced some decision postponement as the liquidity crisis impacted the financial services market.

The credit crunch also impacted revenue for the company's US Credit Services business, as demand for credit reporting decreased and revenue declined for the quarter.

Finally, as you can see on the pie chart, the three business lines maintained a stable mix over the last year with NPS, GOS and BS&S accounting for 35%, 40% and 25% of our second quarter fiscal 2009 consolidated revenue respectively.

About one-third of our revenue is generated from a relatively stable US Federal market, with another one-fourth coming from the BS&S segment. This diversity in breadth of our mix helped mitigate us from some downside during normal economic slowdowns, while still providing growth potential for those who seek to turn to IT Systems and outsourcing to reduced cost in the longer term.

Now let’s move to OI on Slide 16. The second quarter OI margin was 6.7%, just below that of the prior year. The comparatively higher margin for NPS is due to the prior year's $42 million charge related to our long-term development implementation contract with the IRS.

Within GOS, higher SG&A cost were incurred for new business efforts, including adding new customer relationships executives and local branding initiatives. In addition, as we noted last quarter, the startup cost issue on the GOS contract would impact this quarter.

We also incurred costs to reduce an offshore staff, which is reported in operating costs impacting the OI margin versus the special line item we used previously with our formal restructuring program. The net impact of all the above was 1.5 percentage point decrease in OI margin for the GOS line of business.

Within BS&S Financial Services, software license sales were down about $9 million versus last year's strong second quarter. Also the company expensed the movement of a Financial Services data center at approximately $5 million of costs, which will yield benefits on a go-forward basis.

By the way, in the supplemental slide information at the back of the presentation, we have included the fiscal 2008 quarterly breakouts for revenue and operating income by line of business, so you have the comparative baselines for the rest of this fiscal year.

Let's now view our results from an income statement perspective on slide 17. Again, revenues were up 5.5%. Operating costs, as a percentage of revenue, increased slightly from 93.2% same quarter last year to 93.3%. The components that makeup the 93.3% are cost of services, which accounted for 80.5%, a 0.5% lower than the second quarter in 2008.

As I mentioned earlier, the primary drivers were the $42 million pre-tax charge of NPS in the second quarter of last year, partially offset this quarter by the reduced Financial Services license sales and the GOS contract startup issue. Business unit SG&A, excluding corporate G&A, is the second component of operating costs, and was 5.5% of total revenue, up by 0.5% from the same period last year due to the company's increased new business efforts with a customer relationship executives and local branding I noted earlier.

We saw an increase in legal fees associated with the Colossal class action litigation in Q2, as we are preparing for the class certification hearing in early December, and our legal counsel has been engaged in settlement discussions and mediation hearings as well.

Turning to the third component of operating costs, the lower cost of services and higher SG&A offset each other, but depreciation and amortization are up 0.1% primarily due to additional software amortization. Other income consists primarily of foreign exchange gains and losses. Last year's second quarter included an overall foreign exchange gain while the fiscal 2009 second quarter was near breakeven due to CSC's expanded hedging program.

Our income tax provision for the second quarter included the credit for the IRS resolution offset by the tax-related provisions under FIN 48 and international tax audits I mentioned earlier, and as reported, EPS of $2.95.

Next, let's review our balance sheet on slide 18. Cash and cash equivalents increased from $699 million at the end of last fiscal year to $742 million at the end of the second quarter, as the company deliberately maintained higher cash balances as a result of the September 2008 credit market dislocations.

We built up an additional $140 million of incremental cash in September to prepare for further contractions in the credit market. We continue to issue commercial paper to add to the incremental cash in October after quarter-end, until we drew down the 1.5 million credit facility and decided to withdraw from the CP market.

Accounts receivable decreased by $321 million during the first six months of fiscal 2009, aided by the company's collection efforts and reduction of unbilled balances. As a result, DSO improved to 91 days, 11 days lower than the same quarter last year.

Total interest-bearing debt increased by $300 million during the first half of this fiscal year, including the increase in the commercial paper borrowings to bolster our cash position.

As Mike mentioned on October 22nd, CSC borrowed the $1 .5 billion available under its committed revolving credit facility which expires July 12, 2012. CSC took the action due to the instability in the commercial paper market. The primary use of proceeds was to repay maturing commercial paper and term debt. We are discontinuing issuing commercial paper in light of the market volatility.

Let me give you some particulars about the terms of the drawdown. The borrowing is good until July 12, 2012. The loans interest rate is LIBOR plus 32 basis points. We can choose the interest period for either one, two, three or six months and will use the corresponding LIBOR to fix the rate for that period. The interest rate for the initial draw was fixed at 4.1% for the first six months based on six month LIBOR.

Now, let's focus on cash flow on slides 19 and 20. We had a strong free cash in flow of $166 million in the second quarter, an improvement of $181 million as compared to the $15 million outflow for the same period last year. Cash flow generated from operations was $401 million, an increase of $87 million over last year's second quarter.

Capital spending which excludes acquisitions was approximately $235 million in the second quarter, $94 million less than the second quarter last year. The $371 million IRS resolution is non-cash, as it relates to reductions in the company's tax liabilities for uncertain tax positions, and related accrued interest and penalties.

Slide 20, looks at the cash flow performance on a year-to-date basis. Operations generated $345 million cash in flow in the first six months, an increase of $437 million from the comparable period last year.

The change in working capital was the key driver to the improvement. Working capital increased approximately $402 million during the first six months of fiscal 2009 compared to an increase of $966 million for the comparable period last year.

The change in working capital was primarily driven by the accounts receivable improvement. Accounts receivable decreased to $321 million during the six months year-to-date compared to an increase of $314 million in the prior year period. And again, DSO improved to 91 days for the second quarter from 102 days for the same period of fiscal 2008.

Let's move onto slide 21, which updates the trend of our DSO and free cash flow. The left chart shows our DSO was 11 days lower than the second quarter last year. By the way, of our top 25 commercial clients, about three quarters are rated investment-grade with the balance about evenly split between not rated and non-investment grade.

On the right hand of the chart is the free cash flow trend. As I mentioned before, the primary drivers for the cash flow improvement include improved day sales outstanding, higher earnings and lower capital expenditures.

Let's move to ROI on slide 22. ROI is the trailing 12-month profit before interest and after tax margin multiplied by the investment base turnover and we got a strong boost this quarter from the IRS resolution.

Now let's talk a bit more about our operating margins and support for our outlook. On slide 23, it is evident that we have a history of stronger second half performance. During our first quarter call, I talked about some of the items, which improved margins as we go through the year.

Items like fixed cost items in Global Outsourcing like large enterprise software costs, which are relatively fixed independent of volume. So as revenue grows, we pick up additional margin as that fixed cost is a smaller percentage of growing revenue.

Also, workforce optimizations, which take place in the first half for the year to yield benefit by the end of the year. In summer calendar, the fourth quarter has the largest number of billable days as it has fewer vacation and holiday than absences.

Given our targeted 25 or greater basis point improvement for the year, our second half performance has to approach 10% OI margin. How do we get there?

If you turn to the next slide, we've taken numerous actions in the first half to generate results in the second half. We've realigned headcount reducing approximately 2,300 heads including Director and Vice President levels, primarily in the US and about evenly split across the three lines of business.

Offsetting the headcount reductions are approximately 3000 new hires in India, and other low cost locations, giving us a higher offshore mix, which will drive incremental second half margin compared to last year. We’ve also opened directed cost reductions on discretionary and non-billable or overhead and G&A type activities to improve margins year-on-year.

From a total operating incomes perspective, the incremental margin of the second half revenue compared to last year, translates into approximately $75 million plus. From a line of business perspective, we project incremental margin improvement second half year-on-year to breakdown as $5 million to $10 million at NPS, $20 million to $30 million at BS&S and $40 million to $50 million at GOS.

NPS will benefit from their headcount reductions and collapsing of some divisions, eliminating some senior positions. The increase at BS&S results from improved utilization and stronger year-on-year performance at CSC India, as they rationalize legal entities, back offices, and they pick up the pace on new business, as well as NHS revenue increases in the second half providing a mixed benefit.

GOS performance is the biggest improvement with benefits from greater off-shoring, headcount reductions including higher level personnel, and clearing the headwinds from some contract issues affecting last year's second half.

Well not an operating item, the draw down of the credit facility will have an adverse interest expense pre-tax of about $16 million in the second half, while the IRS resolution will reduce tax related interest expense by about $12 million in the second half with the two sort of approximately washing out.

So that leads us to our guidance on page 25. This table represents guidance for the third quarter and full fiscal year viewed from our budget currency translation rates and forward translation rates from November 4. Fundamentally adjusting for the Q2 net tax benefit, we'd be within the range of previous guidance if exchange rates hadn't taken such a dramatic turn, and you can see that from the left side of the slide.

Our original guidance is $4.20 to $4.40 per EPS. Absence currency movements and the net tax benefit, we tightened that range from $4.20 to $4.30. The net tax benefit when added to that gives the GAAP EPS guidance of $6.45 to $6.55 at the budgeted currency translation rates.

At November 4, forward translation rates for our major currencies and spot rates for others, the recent currency exchange rate movements have a significant impact knocking off 2 percentage points on revenue growth on the base line guidance for the year and about $0.15 of EPS.

Not only is more of our income in the back half of the year, but the mix of US versus international has an increase in international's share in the second half, particularly in Europe.

So as the slide indicates, assuming the currency exchange rates as profiled, we anticipate revenue for the third quarter to be in the range of $4.1 billion to $4.2 billion, and earnings per share to be in the range of $1 to $1.10. For the full year we project revenue to be in the $16.8 billion to $17.8 billion range and adjusted EPS to be 4.05 to 4.15, which when added to the net taxed items yields a GAAP EPS projection of $6.30 to $6.40.

The Q2 IRS resolution benefit of $2.43 loses about $0.02 in a rounding, when you get to a full year share based calculation. Tax rate assumptions for the full year when adjusted for the net tax benefit from the IRS resolution and the increased provisions for the international audits is mid to upper 30% with Q3 at nearly 40% and Q4 at mid-30% with the swing due to the timing of discrete items. We are projecting good OI margin improvement in Q3 compared to last year, but we're seeing adverse movements below the operating line.

Last year's Q3 has reported EPS was $1.06 and included about $0.05 of restructuring special items. It also included foreign exchange gains. We don't forecast those gains or losses in our guidance and that's about a $0.09 swing in that line item. Q3 last year also had a much lower tax rate than we are projecting for this year's Q3, which is about an $0.11 swing. So we've got about $0.20 of headwind in the comparison for those below the operating items. We will maintain our free cash flow guidance of 80% to 90% of adjusted net income, excluding the impact of the net tax benefit and net income.

Before I close, there has been a lot written about companies with defined benefit pension plans. I would like to give some more background about CSC's plans and some additional insight that's not evident from our 10-K pension footnote.

Looking at slide 26, in the US our pension plans are contributory and, therefore, not all eligible employees participate. As shown in the fiscal 2008 Form 10-K, CSC's contribution was $126 million and the employees contributed $47.5 million for US plans for fiscal 2008. The US plan benefits are based on the participant's career average salary not the last few years of service.

About half the participants are employees in NPS and, therefore, a portion of any increase or decrease is offset by cost reimbursable contracts. Also, if one focuses on the underfunded status of US plans, one needs to understand a majority of the underfunding of the US plans as shown in the 10-K footnote is due to two non-qualified supplemental defined benefit plans, which are unfunded. As with all unfunded plans, market returns do not impact the expense, funding levels or funding status of these supplemental plans.

Looking at slide 27; for CSC's non US plans, which is principally a defined benefit plan in the UK. The plan design is much the same as in the US. It is a contributory plan, and therefore not all employees participate. UK plan is closed to new employees, except for employees coming to CSC through an outsourcing contract who were previous members of defined benefit plan. Outside the US, CSC's pension plans had underfunding of $233 million at the end of 2008. Although smaller about 15% of the underfunded liability is for unfunded plans.

Let's turn briefly to a sensitivity analysis of CSC's pension plans on page 28. We have looked at CSC's pension plan performance through September 30th calendar year-to-date, which showed a negative return on a global basis of approximately 16%. As was disclosed in the 2008 Form 10-K, holding all other assumptions constant, for every 0.5 percentage point increase or decrease in the expected rate of return, CSC's global pension expense would decrease or increase by $19 million.

But in an analysis such as this, you need to consider the changes and other factors such as interest rates, which determine discount rates. And pension expense is much more sensitive to the discount rate. Again from the 10-K, for every 0.5 percentage point increase to the discount rate, our pension expense decreases $48 million or almost 2.5 times the impact from the expected rate of return.

On slide 28, we have laid out a scenario to give you a better sense of the impact of current market conditions on CSC's pension expense and important contributions.

For fiscal 2009, we recap the pension expense and funding levels for CSC's US pension plans and its non-US plans. We then estimated those factors using September 30, 2008 as our pension's measurement date in lieu of March 31, 2009, which is our next required measurement date.

For fiscal 2010, CSC's pension expense would decrease by $45 million in the US and increase by $18 million outside the US. In the US, employer contributions will increase by $49 million. Although, the market value of assets decreased from the last measurement date, there are several reasons the fiscal 2010 expense decreases from fiscal 2009 under this hypothetical scenario.

The first reason, which applies to US only, is that any impact of asset returns less than expected return is smooth before it’s factored in the expense calculation. For example, this year's shortfall will be averaged with asset values over three-year period to calculate the unrecognized loss.

GAAP allowed companies to average up to five years. We use three. This loss is then amortized over the remaining service life of the participants.

The second reason is the discount rate CSC uses, reflects the market rate for high quality, fixed income debt instruments as of the measurement date. These rates increased over the past nine months, and therefore, the assumed discount rate would have increased almost one percentage point over that period.

The higher discount rate causes the pension expense to decrease more than the lower asset values cause pension expense to increase.

Outside the US, the majority of the impact is driven by the UK plan. In UK, any increase in funding would depend on an agreement between the UK plan trustees and the company. These funding agreements or recovery plans are discussed and finalized every three years.

The last one was finalized in mid fiscal 2008, but the company agreed to make the additional funding payments retroactively to the second quarter of fiscal 2007. Therefore, while three years, the mid-fiscal 2008 to mid-fiscal 2011, it's possible that any additional increases in the employer funding for non-US plans could occur earlier. So, hopefully, that gives you some more background about our pensions.

So, to conclude my remarks for the second quarter, we achieve strong cash performance and significant improvement in DSO. We significantly enhanced our liquidity with a drawdown of our credit facility. We've established the foundation from margin improvements in the second half of the year. And I must caution that currency fluctuations may continue to effect the company's projections.

So that concludes my comments and let me now turn the things back over to Bill.

Bill Lackey

Thank you, Don. Operator, we're now ready to take questions please thank you.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question today is from Rod Bourgeois from Bernstein.

Rod Bourgeois - Bernstein

Thanks for the continued improvement in the disclosure here and the slides, it's all very helpful. I wanted a little more detail on the free cash flow outlook. You've got the year-over-year improvement in free cash flow, but it looks like you're leaving your full year guidance intact?

Have you created more buffer for yourself in this second half of the year on your free cash flow guidance, that you are just leaving it in place to be conservative, or are you expecting different headwinds in the second half that weren't anticipated prior to your upside in the quarter that you just reported?

Don DeBuck

Rod, it's Don. Listen, thanks for those comments about the disclosure. Thank you very much for that. I think as I commented that we've got certainly some of the capital expenditure, we view as timing and so, I think some of that's going to come back the other way. We're very pleased with our DSO performance. We are not satisfied yet. We're going to continue to work that. So, I think we are leaving the guidance where it is for right now, but I'm emphasizing we will continue to work very, very hard.

Rod Bourgeois - Bernstein

Can you specify what your DSO assumption is embedded in your cash flow guidance? I was assuming maybe a five day improvement for the year was already embedded in the guidance, and you seem to be exceeding that assumption on the DSO front. Do you have a new DSO assumption for your free cash flow?

Don DeBuck

You are right, five days was about what we talked about at the Investor Day for improvement, we're certainly tracking more favorable to that. I would like to just let the results speak for themselves, as we come through that without getting into the specifics.

Rod Bourgeois - Bernstein

But should we assume if you keep your DSO's at the current level that you are in a position to exceed your free cash flow target for the year, or is there an offsetting item that would preclude the free cash flow guidance from being exceeded?

Don DeBuck

Again I would say there is timing, there is projected timing on the capital expenditure profiles that are having us leave our guidance where it was.

Rod Bourgeois - Bernstein

Okay, great.

Don DeBuck

Okay.

Bill Lackey

Thanks, Rod. Next question please, Operator.

Operator

Our next question is from Adam Frisch with UBS.

Adam Frisch - UBS

Thanks. Surprised Rod didn't ask about the pension. I do want to offer my thanks for all the color there. A quick housekeeping item; was the guidance change just based on FX or was there also a change in business fundamentals?

Don DeBuck

I think as we have laid out for you on the translation rates on the left part of that slide on 25, the original guidance, we have tightened it by $0.10.

Adam Frisch - UBS

Right.

Don DeBuck

So I would say that there is a bunch of moving parts, but we would absent these changes in the currency rates, , we would be with the original guidance.

Adam Frisch - UBS

That's perfect. On the bookings front, the trailing 12 month year-over-year comps were positive again for the second quarter in a row. That’s usually a good omen for some revenue acceleration and ultimately some margin expansion a few quarters later. Can you talk a little bit about your pipeline and what you think you’re going to do in the back half for the year and whether or not you think the trailing 12 will remain positive?

Mike Laphen

Adam this is Mike. We are pleased with the pipeline. We gave you some color on the pipeline. I think both in the NPS sector and in the outsourcing sector, we would expect to see some upward movement there with the activity that’s going on. We are seeing some robust activity in the outsourcing market, I think some of it as a result of the macroeconomic conditions.

But as you said, that lags a bit, and I think that's more towards a six month window. I guess what we are being a bit cautious on is the discretionary spend in our Business Solutions and Services. So we are trying to balance the impact of those two and incorporate that as well as we can in the guidance that we are giving right now.

Adam Frisch - UBS

Okay, thanks. And then just one follow-up on NHS; touched on it in your comments. We are hearing some delays, some postponements out there. All the things that we are hearing about in the media and I think with this contract you can't always believe what you read, but the kinds of delays that we are hearing about, are those incorporated in your guidance and we should not expect an adverse impact if we continue to see these kinds of developments with NHS.

Mike Laphen

People tend to sometimes focus on some of the negative press that comes out of the UK. There is also a lot of positive press that comes out, and particularly from the NHS. Our confidence continues to build on the program. We are pleased with our progress. Where we are today is incorporated into the guidance. So the user response has been very positive at the early adopter sites. So it's a matter of making sure that everybody is absolutely comfortable with turning the switch all live, and I think we are getting very close to that. But where we are today in terms of schedules is built into our guidance.

Adam Frisch - UBS

Great. Thanks. Good job.

Bill Lackey

Thank you, Adam. Next question please operator?

Operator

Our next question comes from Bryan Keane with Credit Suisse.

Bryan Keane - Credit Suisse

Hi. Just to follow-up on that. I guess my understanding from talking to people in the UK is that the implementation or rollouts are behind schedule from kind of the original plan, and that the schedule to go life has been postponed. I know it’s in your guidance, but can you talk about kind of what was the original plan to where you are now?

Mike Laphen

The original go live was I believe -- I don't want to speak for the NHS. But I think it was around the September timeframe. We’re obviously past that. We don't expect to be much further past that. I think it’s just a matter of the customer getting completely comfortable with the software. Again, I think, if you speak to the hospital sites where we have deployed it with the earlier adopters, there's very positive feedback.

As I mentioned in my comments, the CEO of the Morgan Bay Hospital, which is the acute care hospital, major hospital has spoken very positively about the functionality in the program. So the NHS has taken the position that that they want to absolutely ensure that they have patient care, patient safety is the number one objective and if that takes a little bit longer, then that's the path we're going to go down and we're supporting them on that.

Bryan Keane - Credit Suisse

So for the whole operation to go live, it's probably going to take some time and I assume it will be stagnated going forward. How is that going to impact kind of the financials, kind of what you had original thought to where it is going to look like now?

Mike Laphen

Everything is incorporated into the guidance as to where we are exactly right now. As I said, our confidence continues to build in the program.

Bryan Keane - Credit Suisse

And the new live time frame is scheduled for this quarter at some point?

Mike Laphen

I don't think the NHS has struck a specific date on that. I think it's simply when they feel they are ready to turn that switch and we think it will be sooner rather than later. But I don't want to speak for them as to, explicitly when that is. They have not set a specific date.

Bryan Keane - Credit Suisse

Okay. One last question, Don. I didn't catch, I know there is some acquisitions and there the organic growth in the quarter?

Don DeBuck

We talked about the first consulting group was the acquisition and I gave to reference to how much it is within BS&S, particularly the Financial Services. Our Q has now been filed up there and you can get the specific how that lays out for the composite, for the company or the individual slices from the segment if you want from the 10-Q.

Bryan Keane - Credit Suisse

You don't have it handy, the organic growth?

Don DeBuck

I'm flipping, right now is 1.7 % of the total.

Bryan Keane - Credit Suisse

1.7. Okay. Thank you very much.

Don DeBuck

Okay.

Bill Lackey

Thanks, Bryan. Next question please?

Operator

Our next question comes from Moshe Katri with Cowen & Company.

Moshe Katri - Cowen & Company

Hi, thanks. NPS, I think you said grew about 3% for the quarter. The pipeline is strong, and I guess the real question here is what do we do to get growth to accelerate in that part of the operation given the fact that it should be defensive in the current environment? Thanks.

Mike Laphen

Yes, Moshe. As we said, we had some contract close downs that negatively impacted the number for this quarter. We're projecting 6% for the next quarter, given some of the recent wins we have had. We continue to have a good pipeline there. I think Don gave a full year growth number of 5% to 7% for NPS. I think that's a reasonable projection at this point in time based on what we see and what we feel out there.

Moshe Katri - Cowen & Company

Is there anything that we should be aware of in terms of policy changes given the new administration looking at the public sector side of the business?

Mike Laphen

Well, I think it's a little too early to project that. I think we would all probably assume that there's going to be some level of shift from defense to citizen services. I think it's probably going to take up to a year to really see that reflected in the budgets themselves and in the programs themselves because it takes that long to get people in place and the opportunity to review things.

From our standpoint, and given our footprint in both the civilian agencies and the defense, I think we're extremely well positioned. I don't think IT spending is going to go down across government in general. And I think there's still, I know the wave of retirements of current civil servants is, that wave is still coming and I don't think there is going to be any choice but to continue to contract out for IT service support. So I think the general consensus around here in Washington is that we're not going to see a significant change at least for a year out.

Moshe Katri - Cowen & Company

And last question, can you make any comments on the integration of the acquisition in India? Are we done with the integration efforts, where are we at?

Mike Laphen

India is integrated. It's all under Raj Vattikuti front to back. So the CSC legacy and the Covance's resources are totally integrated into one business unit.

Moshe Katri - Cowen & Company

Thanks.

Bill Lackey

Thank you, Moshe. Next question please operator?

Operator

Our next question comes from George Price with Stifel Nicolaus.

George Price - Stifel Nicolaus

Hi, thanks for taking a couple of questions. And I very much appreciate, Don, the historical segment data.

Don DeBuck

You're welcome. Thank you.

George Price - Stifel Nicolaus

The first question goes back to the original guidance. You tightened it down $0.10. So obviously there is some sort of change implied in that. Is that driven by discretionary? Just as you see the macro environment evolving as it is. Is there something else in there?

Mike Laphen

I think it's fair to say that it's our caution around the macro environment. I think as we looked at it and looked as we gave you the range of 4.20 to 4.40, we thought there was more downside risk than upside potential given what we see in the macro picture. So we thought it best to tighten it up a little bit.

George Price - Stifel Nicolaus

Okay. Now totally understandable, I want to make sure that was what we were talking about. Just on the free cash flow, you mentioned some timing benefits for CapEx, it sounds like you expect to come back in the second half. Can you be a little bit more specific about what those are? Given your focus on cash in the near term, did you just defer some CapEx?

Don DeBuck

No. It’s really more customer driven and customer timing than it is internal CapEx. So it may just be the timing of working with customer programs, as where we may have a capital refresh requirement et cetera, those kinds of things.

George Price - Stifel Nicolaus

Okay. And then I guess, last thing, just stepping back, I wondered maybe get your thoughts. Mike, I know you talked about this, just on the valuation of the stock and the company. Obviously everything has been hit incredibly hard, nobody likes looking at the screen and 401(k) at this point. But arguably the stock price is almost entirely attributable to the potential value of your very strong federal business. Any thoughts at this point on that?

Mike Laphen

No. I think the stock price just reflects the craziness in the market. And so I don't think it reflects a specific business unit or element of the business. From my perspective, it’s an irrational market at this point in time and it reflects an irrational price.

George Price - Stifel Nicolaus

Okay. Quickly for Don, what was the pro forma tax rate?

Don DeBuck

It’s about 40...

George Price - Stifel Nicolaus

44?

Don DeBuck

I was going to say about 43, I think.

George Price - Stifel Nicolaus

Okay. Thanks.

Don DeBuck

Excluding the net IRS items.

George Price - Stifel Nicolaus

Okay.

Mike Laphen

You know the items….

George Price - Stifel Nicolaus

Yeah. Thanks very much.

Bill Lackey

Thanks, George. Next question, Operator?

Operator

Our next question comes from Julio Quinteros from Goldman Sachs.

Vincent Lin - Goldman Sachs

Hi, thanks. This is Vincent Lin sitting in for Julio. I guess the first question is in terms of the demanding environment, I just wondering if you can provide a little bit more color in terms of the demand environments here, US versus the rest of the world, specifically in Europe for your commercial business.

Don DeBuck

Can you say it again?

Vincent Lin - Goldman Sachs

I was wondering if you can provide more details and commentary in terms of how you see the demand environment shaping up here in the US versus the rest of the world, specifically in Europe given your exposure there?

Mike Laphen

Well, I don’t think we're seeing all of that much difference between the US and Europe. What we're seeing I think, what most our industry are seeing is a slowdown in the decision process on a discretion spend. We've been incorporated that I mean to a numbers. We're fortunate that, we have a large public sector business both in the US and in Europe. So that keeps us well balanced and we are seeing active interest in out sourcing in both US and Europe. So I think like everybody else, we are seeing some softness in the discretionary spend, particularly in I would say in financial services and automotive.

Vincent Lin - Goldman Sachs

Understood. And related to that for financial services, I'm just wondering into the month of October and so far in November, have you seen that vertical has stabilized, or is the trend to continue to worsen for that vertical specifically?

Mike Laphen

Well, we are not seeing any major differences. But you have to take into consideration that a significant portion of our financial services work is in the insurance side of financial services as opposed to banking.

So again, I think we're a little less exposed and seeing a little less of the impact than what some of our competitors might see who are involved significantly in the capital markets and also the retail banking.

Vincent Lin - Goldman Sachs

Got it. And lastly, I think we know the answer just given the timing. But for the incoming CFO, just wanted to confirm that he wasn't involved in the planning process as far as the revised that guidance is concerned?

Mike Laphen

No, he has not been involved in any of the financials.

Vincent Lin - Goldman Sachs

Okay. Great. Thanks.

Bill Lackey

Thanks. Next question please operator?

Operator

Our next question is from David Grossman with Thomas Weisel.

David Grossman - Thomas Weisel

Thanks very much. Don, a quick question getting back to your guidance: Can you give us a sense for what kind of assumptions you're making going forward in the second half of the year or what the constant currency revenue growth we should think about in terms of the guidance for the third and fourth quarter?

Don DeBuck

Well, again, for the calculations that we did, we went and used the six month forward projections for the key currency as we noted there on the bottom of the slide. From a constant currency perspective, it would look like for the full year, we'd be at about 7.50% to 8% on a full year basis constant currency. Is that what you were looking for?

David Grossman - Thomas Weisel

Yes, exactly. And then in terms hedging -- I assume that you do hedge. Do those hedging gains and losses show up in other income on a net basis?

Don DeBuck

Yes.

David Grossman - Thomas Weisel

Okay. And can you just tell us what those were in the quarter?

Don DeBuck

They balanced out basically nothing between the cost of the hedging and any gains we got, basically just was so small to not even bother putting it on the slide; under 200,0000.

David Grossman - Thomas Weisel

And that includes the balance sheet translation adjustment as well?

Don DeBuck

Not the translation adjustment. The hedging cost for the balance sheet foreseeables would be in that, but the translation adjustment appears on the other comprehensive income as an adjustment.

David Grossman - Thomas Weisel

Okay. Mike, going back to the NHS, I know there have been a couple of questions about this already. Could you remind us of what the milestones are, as the major milestones in the contract?

Mike Laphen

We've got two major milestones in the second half. One is the final sign-off on Primary Care Solution that supports the general practitioners, and the second one is the sign-off on release one that is out on the early adopters. So those are the two that we need to make happen in this half and we are feeling reasonably comfortable that we’re going to accomplish those.

David Grossman - Thomas Weisel

So the things that have been referenced in the press are primarily the release one, as the early adopters, is that right?

Mike Laphen

Yes, you've got to remember that things in the press aren't just about CSC. There is another provider out there working on the NHS program, and some times there is no distinction made between the two providers. So again, I would direct you to the specific hospitals or the specific centers where we are working and check that feedback. And I think you will get very positive feedback.

David Grossman - Thomas Weisel

Mike, was it sounds like release one, you've got the three adopters that have to sign off. On the GP side, how does that approval process work? Is there a centralized…

Mike Laphen

Yes, that’s a centralized one. As I understand it, it’s a single instance that supports all the GPs and there is a single sign-off on that.

David Grossman - Thomas Weisel

Okay. And has that…

Mike Laphen

You are taking me a little deep here. We will get you more details if you need it.

David Grossman - Thomas Weisel

Okay. And just last thing on the NHS then. In terms of the milestones, are we talking just about cash flow milestones for fiscal ‘09 with the implications of earnings in fiscal '010 as it rolls out, or they are earnings and cash flow implications for the milestones in fiscal ‘09?

Don DeBuck

Yeah, there are both. Achievement of the milestones brings certain revenue recognition milestones as things come out of work-in-process and have revenue and recognized and associated with the margin and then the cash as well.

David Grossman - Thomas Weisel

Okay. Just to close that out, can you give us any sense at least in ranges, just what kind of exposures we have if you know for some reason it does get pushed in fiscal '010 in terms of the implications to either cash flows earnings in fiscal ‘09?

Don DeBuck

Look, we think we’ve calculated all of that within our guidance, and I would like to leave that at that.

David Grossman - Thomas Weisel

Okay. Great. Thanks very much.

Don DeBuck

Okay.

Bill Lackey

Thank you, David. Operator we have time for one final question please.

Operator

And our last question comes from Greg Smith with Merrill Lynch.

Greg Smith - Merrill Lynch

Yes. I was little confused on what you said about offshore headcount. I thought I heard there were some reductions but also some incremental shifts. Can you just kind of clear up what went on with regards to your offshore headcount?

Mike Laphen

Sure. We have taken significant reductions in headcount in higher locations if you will, and a lot of that primarily within the US, in the Americas. So what I was trying to say in around numbers it's about 2300 reductions globally but the bulk of those in the Americas. But at the same time, we have hired about 3000 people in India. And it is not necessarily one-for-one of this job was reduced and a corresponding job was hired in India. They may be completely different in terms of what functions they perform and how available they are.

Don DeBuck

I am just trying to give a sense of, there is clearly a mix happening of, the balance of CSC's employee population is decreasing relatively in the higher cost locations and increasing in the lower cost locations.

Greg Smith - Merrill Lynch

Okay. And so all those the reductions all ran through the P&L, any severance ran through the P&L this quarter?

Don DeBuck

That's right. And that's the point that I tried to make that, two plus years ago we had the formal announced restructuring program, where those costs appeared in the special items line. And as we said at the investor day, we wouldn't do that anymore. We weren't going to have those formal restructuring programs. We would be doing this, as the situation arose and therefore we flow through normal operations.

Greg Smith - Merrill Lynch

Okay, perfect. Then only debt you have coming due well within the next couple years is in '09, you have a couple $100 million and then nothing else till 2011 or 2012 I think?

Don DeBuck

That's right.

Greg Smith - Merrill Lynch

I am sorry go ahead.

Don DeBuck

No, I was going to say the $200 million that's due at the end of our fiscal year here and then nothing next fiscal year.

Greg Smith - Merrill Lynch

Yes. The cash we see on the balance sheet, the $742 million, how much of that is in the US and then is that all freely available to you?

Don DeBuck

Are you talking about with the drawdown of the credit facility or for just what's on the balance sheet there?

Greg Smith - Merrill Lynch

What's on the balance sheet today, I mean because that represents already drawing down the credit facility, does it not?

Don DeBuck

No, again that's very important to understand. That's an October 3rd balance sheet and we didn't drawdown the credit facility to mid-October.

Greg Smith - Merrill Lynch

Got it. Okay.

Don DeBuck

So it does reflect the drawdown of the credit facility. It does reflect that we had started to build incremental cash because we started to see the commercial paper market not working very well and I must say it has worked for us for many, many years and we had dealers who were pre-approved to sell CSC paper. And with the acquisition we did have commenced last year. We initially did that with commercial paper. So it was a market that worked for us very well for a long number of years.

But as we came through the end of September, it just became an increasingly troubled market. Those who buy commercial paper think of money market funds who could not predict the redemptions that they were going to see the next day started going for very short maturities. One day rather than the previous much longer-term maturities we were able to sell in the commercial paper market.

So as past maturities began to mature and they were rolling over into more and more was rolling over to one day, we had more and more of our CP paper that we have to go on and sell in any given day. And we just got to the point in mid-October where we said this is just, we are spending far too much time talking with the dealers about what used to be an easy thing to do about selling our commercial paper, about how they were going to sell it [that day]. And we just decided to pull the credit facility.

Greg Smith - Merrill Lynch

Yeah, okay. And then just, I don't believe you said what tax rate is assumed in your guidance for 3Q and 4Q?

Don DeBuck

I did. I can repeat it here for you. Give me one second here. Again, adjusting for the net tax benefit from the IRS resolution increased provisions for the international tax audits. It's mid to upper 30% with Q3 at nearly 40% and Q4 at mid 30%.

Greg Smith - Merrill Lynch

Okay, great. Thank you.

Don DeBuck

Okay.

Bill Lackey

Yeah. Thank you, Greg, and Operator, let's conclude our call. We want to thank everyone who dialed in and we will talk to you next quarter. Thank you very much.

Operator

We thank you for your participation on today’s call and have a wonderful day.

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